What is Leverage Ratio?

For any business, securing funding is a tall order. When it comes to doling out money friends, families, venture capitalists, banks, etc. all have their own standards and skepticisms involved. If you are in business and need financing, you would need to understand a few key metrics that determine your financing situation, one of them being leverage ratio.

For businesses and banks, leverage ratios are a useful indicator to gauge how their assets are financed. One can gauge how much capital is coming from debts (loans) or equity. How well a company can meet its financial obligations can be understood by looking at its leverage ratio, hence it is a useful metric for investors and market analysts. But what is leverage ratio? 

Let us take a closer look at leverage ratios and their importance, learn the leverage ratio formula, and also find out what is an ideal leverage ratio for banks and other types of industries.

What is Leverage Ratio

The proportion of debt or loan to equity or capital gives the financial leverage ratio of any company. Banking institutions often use the capital leverage ratio to track finances. Businesses also use this metric to show the level of debt compared to their accounts, for instance, cash flow statements, income statements, or balance sheets.

  • Leverage ratios are a set of ratios that showcase a company’s financial leverage with respect to assets, liabilities, and equity. It is the proportion of debt to cash and assets.

  • If the leverage ratio is high it means that the firm is using debt to finance its operations and assets. This is a telltale sign of a risky bet for potential investors. 

  • A high leverage ratio also shows that the earnings of the entity could be inconsistent. Shareholders will have to wait for a while before they can get a return on their investments. 

  • Another possibility of a high leverage ratio is the company soon becoming insolvent.

  • Creditors use the leverage ratio to decide if they could extend their credit to the firm or not.

  • A financially responsible organization with a steady flow of revenue would have a lower leverage ratio. This shows credit agencies and shareholders that the firm poses minimal risks and is worth an investment.

Calculating Leverage Ratio 

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There are many different types of leverage ratios under the financial leverage ratio umbrella that investors and market analysts consider for deciding upon a company’s financial stability. There are primarily six financial leverage ratios, each having its separate leverage ratio formula which is outlined below:

  1. Debt ratio - This shows how much of a business’s assets (like real estate, property, etc.) are coming from loans. Another name for this ratio is the debt-to-assets ratio. The formula of debt ratio is given by “total debt/total assets” and a debt ratio of 0.5 is considered a good measure. A company is said to be at high financial risk if its debt ratio is more than 1.

\[\textrm{Debit Ratio}=\frac{\textrm{Total Debit}}{\textrm{Total Assets}}\]

  1. Debt-to-Equity ratio - This ratio shows how the firm’s equity stacks up against its liabilities. This is different from the debt ratio as it uses total equity as opposed to total assets in the leverage ratio formula. The debt-to-equity ratio helps lenders understand if most of the company’s operations are financed by equity or debt. The formula of this ratio is “total debt/total equity” and a good debt-to-equity ratio is anywhere between 1 to 1.5 (figures vary based on the industry). A ratio of more than 2 is considered risky. Some companies need huge amounts of funding to maintain their operations, for instance, manufacturing companies. These companies would usually have a higher debt-to-equity ratio.

\[\textrm{Debit - to - equity Ratio}=\frac{\textrm{Total Debit}}{\textrm{total equity}}\]

  1. Debt-to-Capital ratio - The formula for this ratio is “total debt/(total debt + total shareholder’s equity)” and is used by investors to determine their risks of the investment in any company. Total capital is the sum of all the company's debt and shareholder’s equity.

\[\textrm{Debit - to - Capital Ratio}=\frac{\textrm{Total Debt}}{\textrm{total Debt + total shareholder's equity}}\]

  1. Debt-to-EBITDA ratio - The full form of EBITDA is Earnings before interest, taxes, depreciation, and amortization. EBITDA is useful to companies for giving them a clear picture of their cash flow and overall financial health. A low Debt-to-EBITDA ratio denotes a manageable debt load of the company. The acceptable range of this ratio varies from industry to industry so it is best to compare the Debt-to-EBITDA ratio of your business with other businesses that are of similar nature.

\[\textrm{Debit - to - EBITDA Ratio}=\frac{\textrm{Total Debt}}{\textrm{EBITDA}}\]

  1. Asset-to-Equity ratio - The total assets of your company that are funded by the shareholders is measured by the asset-to-equity ratio. Shareholder’s equity can comprise minor interest, preferred stock, or company stock. If this ratio is low it means that your firm has selected conservative financing and has a minimal amount of debt. A high ratio denotes high debt and lenders would refrain from providing additional financing to such companies. 

\[\textrm{Asset  - to - Equity Ratio}=\frac{\textrm{total asset}}{\textrm{total equity}}\]

  1. Operating Leverage ratio - If you want to gain insights into a business’s fixed and variable costs, then you would look at its operating leverage ratio. If this ratio is high it means that the firm has a lower percentage of variable costs and high fixed costs. In such a case an increase in revenue would improve the company’s bottom line. The below formula is used to calculate the operating leverage ratio:

\[\frac{\textrm{(Price - Variable cost of each unit)*(quantity)}}{\textrm{(Price - Variable Cost of each unit)*(quantity) - fixed operating costs}}\]

Hence, this well-written article has covered every vital detail concerning the leverage ratio. 

FAQs on Leverage Ratio

1. What is the leverage ratio for banks?

The leverage ratios of banks are calculated by dividing Tier 1 capital by consolidated assets. Tier 1 capital consists of the company’s equity, retained earnings, reserves, and other securities after subtracting goodwill. The leverage ratio has a special significance for banks since banks are highly leveraged entities. The net worth(Asset - liabilities) of a bank is measured by its capital. The bank capital is split between two major categories:

  • Tier 1 (Retained earnings + shareholder’s equity + reserves) - This is the core capital of a bank and contains items that you would generally see on a bank’s balance sheet. 

  • Tier 2 (subordinated debt + revaluation reserves + hybrid capital + total loan loss + provisions including deferred tax.) - This is a supplementary capital.

A bank’s capital is made up of both tier 1 and tier 2 capital. The tier 1 capital is more indicative of a bank's capability to sustain pressures like bankruptcy. The tier 1 capital is used majorly in the leverage ratio formula for banks. The top 3 leverage ratios for banks are:

  • Tier 1 leverage ratio - The formula is “tier 1 capital/total assets” and this ratio was introduced to keep a check on the amount of leverage possessed by a bank. It also reinforces the risk-based requirements by using back-stop safeguard measures.

  • Debt-to-equity ratio - Banks usually have a very high debt-to-equity ratio as they carry large amounts of debt on their balance sheets since they invest significantly in fixed assets in the form of branch networks.

  • Debt-to-capital ratio - The formula is “total debt/total capital (tier 1 + tier 2)”

Any value above 5 is deemed as an ideal leverage ratio for banks.

2. What is the consolidated leverage ratio?

The consolidated leverage ratio, as of the date of determination, gives the ratio of consolidated funded indebtedness to consolidated EBITDA for the four fiscal quarters that ended recently (for which the borrower has delivered his/her company’s financial statements).